LEWIS A. KAPLAN, District Judge.
This action arises out of statements regarding the internal controls and accounting practices of Weatherford International Ltd. ("Weatherford" or the "Company"), after Weatherford announced in 2011 that it had understated its tax expenses from 2007 through 2010 by over $500 million. Lead plaintiff American Federation of Musicians and Employer's Pension Fund ("AFME") alleges that Weatherford and certain of its officers, as well as its auditor Ernst & Young LLP ("Ernst & Young" or "E & Y"), violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act")
AFME is "one of the largest pension funds in the entertainment industry," with "over $1 billion dollars in assets under management."
The defendants are the Company, Ernst & Young, and several individuals associated with the Company (the "Individual Defendants").
Weatherford is an "international provider of equipment and services used in the drilling, completion and production of oil and natural gas wells."
The Individual Defendants are Ms. Jessica Abarca and Messrs. Bernard Duroc-Danner, Andrew Becnel, and Charles Geer, Jr.
The AC focuses on Weatherford's alleged understatement of tax expenses in its financial statements for the years 2007, 2008, 2009, and the first three quarters of 2010.
According to the AC, the lower rate was of particular interest to analysts and investors. The Weatherford Defendants are alleged to have "closely monitored Weatherford's effective income tax rate, and specifically touted it in numerous SEC filings and analyst conference calls."
This apparently lower rate proved illusory. On March 1, 2011, the Company announced that it would restate its earnings for 2007 through the third quarter of 2010. It stated that it had identified in February 2011 a "`material weakness in internal control over financial reporting for income taxes.'"
According to the statement, the Company conducted additional testing after identifying the material weakness and, in the process, identified tax receivable balances for which, as the Company later explained to the SEC, "documentary support was not available."
In deciding a motion to dismiss under Rule 12(b)(6), a court must accept all factual allegations in the complaint as true and draw all reasonable inferences in the plaintiff's favor.
To state a claim under Section 10(b) of the Exchange Act, a plaintiff must allege facts sufficient "to establish that the defendant, in connection with the purchase or sale of securities, made a materially false statement or omitted a material fact, with scienter, and that the plaintiff's reliance on the defendant's action caused injury to the plaintiff."
A complaint asserting a Section 10(b) claim must satisfy also the heightened pleading standards of Rule 9(b) and the Private Securities Litigation Reform Act of 1995 ("PSLRA").
In addition, the PSLRA requires a complaint to "state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind."
In evaluating whether a complaint alleges facts giving rise to a "strong inference of scienter," courts must consider all the facts alleged, inferences favoring plaintiffs rationally drawn from the facts, and "plausible, nonculpable explanations for the defendant's conduct."
A complaint may satisfy the scienter requirement "by alleging facts to show either (1) that defendants had the motive and opportunity to commit the fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness."
In order sufficiently to allege "motive and opportunity," plaintiffs must allege that defendants "benefitted in some concrete and personal way from the purported fraud."
If plaintiffs have not alleged motive and opportunity sufficiently, they may rely upon the "strong circumstantial evidence" prong, "though the strength of the circumstantial allegations must be correspondingly greater if there is no motive."
AFME contends that the AC adequately pleads that the Weatherford Defendants had both a motive and the opportunity to commit fraud. The contention is unavailing.
The AC points first to the Individual Defendants' discretionary bonuses tied to performance targets and their large compensation packages.
The Second Circuit has recognized that individual stock sales by corporate insiders will provide the requisite motive.
In light of the inadequacy of these grounds for motive, AFME focuses principally on its theory that the fraud inflated Weatherford's stock price and thus permitted it to fund its "aggressive growth strategy" while avoiding becoming an acquisition target in its own right.
The theory is rejected easily with regard to the Individual Defendants because plaintiff "nowhere allege[s] that defendants engaged in these transactions to secure personal gain" as opposed to carrying out their "financial responsibilities to the Company."
More challenging is the question of whether the corporate defendant—Weatherford itself—may be inferred to have had the requisite motive due to its interest in acquiring other companies. While "artificial inflation of stock prices in order to acquire another company . . . `in some circumstances' [may] be sufficient for scienter,"
The Circuit has provided little guidance as to what this "unique connection" must be, but has suggested that it is sufficient when the "misstatements directly relat[e] to the acquisition."
There is an important reason to apply exacting scrutiny to any claim of motive through company acquisitions. A plaintiff who alleges motive and opportunity necessarily has satisfied the pleading requirements for scienter, even without any allegation that a statement that later proved to have been false was made with an indication of knowledge or recklessness.
Likewise, while an acquisition program funded by stock issuances in a certain sense might provide a "motive" to inflate the stock price, it is not sufficient to allege scienter. Accepting AFME's position would allow a plaintiff to proceed to discovery whenever it can allege that a company that is growing through the issuance of equity made a statement that ultimately proved to have been materially false but helped to raise the company's share price. That conclusion is inconsistent with the PSLRA and our Circuit's requirements of a "unique connection" between the fraud and the acquisition, and this Court declines to accept it.
As discussed above, plaintiff alleges two different kinds of false statements by the Weatherford Defendants: (1) those relating to the quality of Weatherford's internal controls and (2) those relating to the understated tax expense.
In every Form 10-Q and 10-K filed during the class period, certain defendants made statements regarding the effectiveness of Weatherford's internal controls. In particular, Duroc-Danner and Becnel individually certified that they were "`responsible for establishing and maintaining disclosure controls and procedures . . . and internal control for financial reporting'" for Weatherford and have, among other things, "`[d]esigned such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles'" and "`disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors . . . [a]ll significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information.'"
By contrast, the Company's March 2011 restatement identifying the "material weakness" detailed significant gaps in its internal controls as follows:
Although the March 2011 restatement specifically stated only that Weatherford's internal control over financial reporting for income taxes was not effective "as of December 31, 2010"
The question, of course, is whether the AC adequately pleads that Becnel and Duroc-Danner made their certifications either knowing they were false or with reckless disregard for their truth.
The Court concludes that AFME has alleged scienter adequately with regard to Becnel's statements about internal controls. In reaching this conclusion, the Court relies on several key factors.
First, the personal participation of Becnel in designing and evaluating the internal controls is relevant to the inquiry. The certifications state that Becnel, along with Duroc-Danner, was "`responsible for establishing and maintaining'" those controls and "`designed'" or caused such controls to be designed under his supervision.
Second, the discrepancies between the admissions of the March 2011 restatement and the repeated certifications that continued from the beginning of the class period until as late as November 2010 are stark. In March 2011, the Company admitted "inadequate staffing and technical expertise," "ineffective review and approval practices," "inadequate processes to effectively reconcile income tax accounts" and "inadequate controls over the preparation of quarterly tax provisions."
Third, the AC alleges that Becnel was aware of at least some problems with internal controls in the tax department during the class period. The AC refers to CW2, a "senior-level audit executive" who worked in Weatherford's internal audit department from approximately 2000 to 2010.
Finally, to the extent the Tax Department posed unique issues, the fact that taxes were "key to measuring [Weatherford's] financial performance and [were] a subject about which investors and analysts often inquired" further "reinforces the inference of scienter."
Defendants' opening brief paid almost no attention to the internal controls statements, contending principally that the alleged statements of CW2 regarding internal audit delays are not relevant. The Court is unpersuaded. Given that part of Weatherford's challenged statements regarded the effectiveness of internal controls to allow "timely"
Defendants challenge also CW2's alleged statements about control deficiencies on the ground that the AC does not allege that those deficiencies related in any way to the $500 million restatement. But that is entirely beside the point when determining whether Becnel's general statements regarding internal controls—which were separate from its understatement of tax expense—were made recklessly. The AC's allegations permit the conclusion that Becnel knew about but failed to resolve meaningful control deficiencies at times when Becnel was certifying that the internal controls were effective. While discovery ultimately may undermine the probative value of the supposed deficiencies referenced by CW2, the complaint is sufficient in this respect to survive a motion to dismiss.
In short, in light of the personal involvement of Becnel in designing and evaluating Weatherford's internal controls, the stark realities about the inadequacies of the internal controls that were revealed in the March 2011 restatement, the audit delays and control deficiencies expressly raised to him during the class period, and the fact that the Tax Department uniquely was experiencing problems even while he knew that its functions were of specific importance to the Company, the AC sufficiently alleges scienter with regard to his statements.
The Court concludes further that the AC adequately alleges scienter with regard to Weatherford.
Next, the AC alleges false statements that relate specifically to the understatement of tax expense, including the Company's reports on Forms 10-K and 10-Q. It alleges that these reports "materially overstated the Company's net income, net earnings, effective income tax rate and purported growth."
To the extent plaintiff appears to allege an intentional scheme whereby defendants "crudely manipulated the Company's effective tax rate expense by a few percentage points each quarter and fiscal year to generate enough earnings to meet or beat the Company's targets in key periods," its allegations are insufficient.
But that is not the end of the story. Plaintiff need not make such grandiose allegations to plead scienter adequately. Rather, plaintiff needs to allege facts plausibly giving rise to an inference of recklessness, "an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it."
Plaintiff puts forward several bases on which to found such an inference of recklessness, including (1) the magnitude of the restatement, (2) the focus of defendants and investors on the effective tax rate, (3) the quality of internal controls, and (4) access to information.
The Court is not persuaded by the AC's attempt to allege scienter regarding the understatement of tax expense based on an access to information theory.
Similarly unpersuasive is the alleged lack of internal controls. While Weatherford's poor internal controls may give rise to liability with respect to the defendants' statements about internal controls, the weak internal controls provide little if any circumstantial support that the statements that the understated tax expense were made with scienter. Simply put, "[w]eak accounting controls may pave the way for fraud. They do not themselves constitute fraud."
This leaves plaintiff's central points—that the magnitude of the understatement and the defendants' and investors' considerable focus on Weatherford's tax rates demonstrate that the defendants were at least reckless with regard to the truth of their statements.
The Second Circuit has held that the magnitude, at least in certain circumstances, can be relevant to the scienter inquiry.
Nevertheless, "it is clear that the size of the fraud alone does not create an inference of scienter,"
That debate need not be settled here. The Court assumes, in light of the importance of tax rates to Weatherford's financials, that the proper determination of these rates constituted "core operations" that would have permitted a plausible inference that the defendants knew about the falsity or knew facts that made the risk of such falsity obvious.
But the fact that the Court may make such an inference does not mean that such an inference necessarily would be the most compelling under Tellabs. The Court is required to consider "plausible, nonculpable explanations for the defendant's conduct" and, in order to sustain the complaint, must conclude that the inference of scienter is "at least as compelling as any opposing inference one could draw from the facts alleged."
AFME challenges three categories of statements made by Ernst & Young in reports appended to each of Weatherford's annual 10-K reports for 2007, 2008, and 2009: (1) its statements regarding the effectiveness of Weatherford's internal controls,
With regard to the third category, E & Y's statements about GAAS compliance, the AC points to several General Standards ("GS"), interpretive Statements on Auditing Standards ("AU"), and Standards of Fieldwork that allegedly are part of GAAS and that E & Y allegedly violated.
AFME contends that each of these three categories of statements was false and that E & Y made such false statements with the requisite scienter.
Plaintiff first posits that it sufficiently has alleged facts giving rise to a strong inference of scienter under the motive and opportunity approach on three types of allegations. The first regard the fees that Ernst & Young received from Weatherford.
The AC alleges only that Ernst & Young "generated over $30 million in aggregate fees" from Weatherford during the class period.
The "revolving door" allegations are similarly unsuccessful. The Court assumes for present purposes that there was, in fact, a "steady stream" of Weatherford employees and executives with "close personal ties" to Ernst & Young.
Finally, the AC provides two paragraphs of allegations of prior wrongs it asserts Ernst & Young committed.
Alternatively, AFME contends that it has alleged the requisite scienter through sufficient circumstantial evidence of conscious misbehavior or recklessness.
In conducting this inquiry, the Court is mindful of the "demanding" standard imposed by this Circuit to plead auditor scienter in a securities fraud case.
Typically, auditor scienter in this Circuit turns on alleging that the auditor "repeatedly failed to scrutinize serious signs of fraud."
Moreover, where, as here, statements by an auditor are couched as opinions, this Court has previously recognized that the bar is raised even higher to allege the requisite scienter. In particular, to allege that an opinion is false (and a fortiori, to allege that it is false with scienter), the complaint must "set forth facts sufficient to warrant a finding that the auditor did not actually hold the opinion it expressed or that it knew that it had no reasonable basis for holding it."
The Court takes each category of alleged misstatements in turn.
AFME relies on what it characterizes as nine red flags to support an inference of scienter regarding E & Y's opinions about Weatherford's GAAP compliance: (1) the sudden drop in Weatherford's tax rate in 2007, (2) the magnitude of the error as ultimately revealed in 2010, (3) the frequency and consistency of the tax entries, (4) the fact that Weatherford's apparent tax rate was much lower than that of its rivals and permitted Weatherford to beat earnings forecasts, (5) the fact that E & Y received fees for "non-U.S. tax compliance, planning and U.S./non-U.S. tax related consultation," (6) Weatherford's prior history of accounting improprieties, (7) the discrepancy between Weatherford's cash tax rate and reported tax rate, (8) E & Y's access to a spreadsheet containing intercompany reconciliations and (9) the discrepancy between E & Y's representations about internal controls and Weatherford's March 2011 admissions.
First, several of these were not red flags at all. That E & Y received fees from Weatherford for U.S. "tax related consultation" says substantially nothing about what E & Y would have known from 2007-2010 about this particular aspect of Weatherford's taxes beyond its general role as auditor. Nor is Weatherford's March 2011 revelation of its poor internal controls a red flag that would have been seen by E & Y in 2007-2010.
Second, at least one of these purported red flags is insufficiently connected to E & Y. The AC fails to allege that E & Y knew about Weatherford's competitors' tax rates or that the tax rates were responsible for beating earnings forecasts.
Third, some of these red flags just are not sufficiently colorful. As discussed previously, the AC fails to explain with particularity whether and how the spreadsheet providing "intercompany reconciliations" would have revealed the understatement of tax expense.
Finally, to the extent that the supposed red flag merely constituted better performance by Weatherford, the Circuit has rejected the notion that a rapid increase in profitability is a sign of fraud sufficient to plead scienter.
The remaining purported red flags amount not so much to any meaningful contemporaneous knowledge that E & Y had showing the existence of any misstatements, but rather that the size and nature of the fraud was such that E & Y should have found it. That is, the AC is "replete with allegations that [E & Y] would have learned the truth as to those aspects of [Weatherford's taxes] if [E & Y] had performed the due diligence it promised."
The allegations regarding internal controls fare no better. The only purported red flag that AFME alleges regarding internal controls is the tension between E & Y's opinion that the internal controls were effective and Weatherford's subsequent conclusion that they were not. But that is not a red flag because Weatherford's conclusion was made known only after E & Y's representations. Unlike in the case of Becnel, the AC contains no allegations suggesting that E & Y ever had been made aware of issues with internal tax controls.
AFME's stronger argument is that, in light of the considerable deficiencies in internal controls revealed by the Company, any reasonable audit following the criteria that E & Y affirmed that it had used would have revealed the deficiencies. But the AC's allegations in this regard are only conclusory, providing no factual detail as to how application of the criteria would necessarily have uncovered the problems with internal controls.
Finally, E & Y's statements regarding its compliance with GAAS is disposed easily. Whether in alleging that E & Y violated its duties of "due professional care," "professional skepticism," or gathering sufficient evidential matter, or otherwise, the claims fall for essentially the same reasons as described above. Indeed, the burden is doubly high in this context; not only must AFME allege that E & Y failed to do an adequate audit, but it must allege also that E & Y was at least reckless in believing that its audit was adequate. There is nothing in the AC that even begins to suggest anything about E & Y's state of mind with regard to how it conducted the audit, and thus the claim fails.
Section 20(a) of the Exchange Act makes liable those who directly or indirectly control a person who is liable for a primary violation of the statute.
The Court concludes that in addition to stating a claim against Becnel and Weatherford as primary violators, the AC states a claim against Duroc-Danner, Abarca, and Geer under Section 20(a). As chief executive officer, Duroc-Danner clearly had "the power to direct or cause the direction of the management and policies" of Weatherford.
AFME moves to supplement the complaint to add factual content that purportedly came to light only after the filing of the amended complaint.
A motion to supplement a complaint pursuant to Rule 15(d) is governed by the same standard as a motion to amend under Rule 15(a).
A motion to supplement generally should be "permitted when the supplemental facts connect it to the original pleading."
At a hearing before this Court on January 17, 2012, counsel for lead plaintiff AFME indicated that they preferred to "go forward"
Be that as it may, AFME asserts that its present motion to supplement the AC should be granted because events have occurred after the date the AC was filed that add substantively to the allegations asserted therein.
The motion is denied as futile. None of the proposed additions in any way affects the resolution of this case. First, that Becnel and another executive were removed well over a year after a restatement in which the Company was forced to acknowledge, at a minimum, a $500 million mistake, is not probative of scienter.
Conclusion
Accordingly, Ernst & Young's motion to dismiss the AC [DI 63] is granted. The Weatherford Defendants' motion to dismiss the AC [DI 67] is granted in all respects, except that it is denied with respect to (1) the Section 10(b) claims against Becnel and Weatherford regarding statements about the quality of internal controls and (2) corresponding Section 20(a) claims against Duroc-Danner, Abarca, and Geer. AFME's motion for leave to supplement the complaint [DI 90] is denied, and its requests for judicial notice [DI 90; DI 101] are denied as moot.
SO ORDERED.
ECA undermines also plaintiff's reliance on a prior decision, In re Interpublic Securities Litigation, No. 02 Civ 6527, 2003 WL 21250682 (S.D.N.Y. May 29, 2003), for the proposition that a sustained growth-by-acquisition strategy not otherwise connected to an alleged fraud provides sufficient motive.
Kalnit and ECA appear to be in some tension with Rothman on this point, because it would seem that any time an inflated stock price permits cheaper acquisition proposals, the lower price paid would inure to the benefit of all shareholders. Because the allegations are insufficient for other reasons, the Court need not resolve any apparent tension among these cases.
"[W]e carried out an evaluation, under the supervision and with the participation of management, including [Becnel] and [Duroc-Danner], of the effectiveness of our disclosure controls and procedures . . . . Based upon that evaluation, our CEO and CFO have concluded our disclosure controls and procedures are effective as of the end of the period covered by this report to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms and that information relating to us . . . required to be disclosed is accumulated and communicated to management, including the CEO and CFO, to allow timely decisions regarding required disclosure."
DI 65, Ex. 15 at 39.
Similarly unavailing is In re Interpublic Securities Litigation, 2003 WL 21250682. In concluding that the plaintiffs did not adequately plead scienter, the court relied on the fact that the company had never admitted that it failed to have the proper procedures in place, a far cry from this case. Nor was there any indication that executives in Interpublic had received any information about internal control problems while the company was certifying that the controls were adequate.
Conversely, if a widget manufacturer states repeatedly that it had annual sales of $100 million when in actuality its sales were only $10 million, the magnitude of that error should provide some support for an inference of scienter, because such a significant discrepancy would be unlikely to go unnoticed.
